Markets Discounting Another Rate Hike

{mosimage}Sentiments in the Indian equities market seems to be on an upturn. The key benchmark indices, Sensex and Nifty rallied by nearly 9.2% and 9.83% respectively during October. This sentiment change was attributable to improved trade statistics; suspension of the US debt ceiling limit & the end to the shutdown; the deferment of the QE3 tapering and the rising market outlook on a stable polity, post the general elections.

The monetary policy stance of RBI has also undergone significant change over the last 1-2 months. The central bank has gradually eased the liquidity borrowing facility under the 7 and 14-day LAF; and has reduced the operational MSF rates from the peak of 10.25% to 8.75%. This has helped normalise the extraordinary liquidity circumstance and has also brought down the yield curve at the shorter end of the yield curve (from June-July highs) and improved the commercial borrowing prospects.

Additionally, the central bank has also gradually increased the repo rate by 50bps in two phases to 7.75% in response to recent buoyancy in the WPI inflation and continued stickiness in the CPI inflation. The market however is of the view that the tone and tenor of the latest policy statement indicates we are closer to the policy rate peak. Market, however, seems to be discounting one more rate hike (taking the repo rate to 8%) in the next policy meet.

The economy is in a high-inflation, low-growth dilemma, and plain monetary policy initiative may not be a response to it. Emphasis on increasing factor productivity is needed, both of capital and labour. The high turnaround time between project conceptualisation and execution and entry and exit barriers for businesses needs to be addressed.

While many of these require regulatory reforms, others can be achieved through process formalisation, transparency and automation. This will increase competition, reduce production costs, enhance product innovation and increase employment opportunities - giving rise to a more sustainable, encompassing growth cycle.

For now, the yield curve of the debt market has steepened as the reduction in the MSF rate has brought down the money market yields. At that the hardening of the repo has kept the 10-year rates above the 8.5% levels. We believe that improved agriculture output and the onsetting lag of reduced crude oil prices may help bring down inflation in the next couple of months. This should pave way for monetary easing, post the uncertainty surrounding the QE3 tapering is over. This is likely to provide equities and debt market a sizeable sentiment shift going ahead.